Texas Tea
“Come and listen to a story ’bout a man named Jed, poor mountaineer barely kept his family fed. Then one day he was shootin’ at some food, and up from the ground come a bubbling crude. Oil that is. Black gold, Texas tea.”
~ The Ballad of Jed Clampett ~
If they were ever going to bring back “The Beverly Hillbillies,” now would be the time. Not only is that Texas tea in Jed’s backyard worth approximately five times what it was worth in 2002, but that mansion in Beverly (Hills, that is) can be purchased for a good 20% discount off the housing boom highs. Jethro could have the biggest cement pond you have ever seen, and Granny could have a proper distillery added to the house. Mr. Drysdale would be ecstatic, as Jed’s business alone might be enough to save his bank from the woes of sub-prime. Can you imagine a more timely show?
Unfortunately, this is not a television situation comedy. The housing slide continues and the credit crisis just seems to linger. However, the big star of this past quarter has been oil, so that will be our focus for this article.
Americans love nothing more than to play the blame game. Whose fault is it that oil is selling at over $140 per barrel? We want a simple solution, like the oil companies are just gouging us, or speculators are manipulating the market. The truth is not that simple, and unfortunately for those who would like to see “justice” done, there really aren’t any bad people pumping up the price of oil just to make our lives miserable, and no matter what your favorite politician promises, there are no quick fixes.
The first eight years of this new century have seen explosive growth in emerging countries, primarily in China and India. Along with that growth has come new-found wealth, and with this wealth, a good percentage of the approximately 2.5 billion people in China and India started trading in their bicycles for automobiles. The demand for oil consequently rose sharply, and as any first-year economics student can tell you, if the demand rises and supply stays the same, the price will go up. Economic theory would suggest that the higher price would cause people to cut back on consumption and would provide an incentive for suppliers to increase output, thereby causing demand to shrink, supply to grow, and the prices to fall back to norms.
Why hasn’t that happened? Let’s take supply first. There was an initial supply response, but supply seemed to peak in 2005 with total production of approximately 85 million barrels a day. There are a couple of reasons why supply has not grown faster. In our fast paced world we forget that getting oil out of the ground takes time, and six years is not a long time in the context of developing an oil field. The largest part of the price increase has been over the last nine to twelve months, and it simply isn’t reasonable to expect results that quickly. Based on capital expenditures of the large oil companies, they are working hard to find and get us more oil, but it doesn’t happen overnight.
In addition, oil is a non-renewable energy source. The world’s existing oil fields are in different stages of their production life, but as a whole, the existing sources are experiencing declines of approximately four percent per year. This means that the first 3.4 million barrels of new daily production simply replaces the depletion from existing wells.
These factors have played a role in the lack of response in the supply of oil, but what has kept demand so high? The reality is that cutting back on oil is not that easy. Sure there are things we can do. Couples with two cars can use the more efficient car as much as possible. We can all plan more carefully to consolidate our car trips and avoid wasted mileage. We can use public transportation and, of course, take better care of your car and check the tire pressure. All these tips can help your pocketbook and the environment, but not driving is not an option for most of us, nor is not heating your home.
The biggest reason there has not been a reduction in the demand side of the equation is because of government subsidies for oil. Fuel subsidies are widespread in emerging-market nations. Morgan Stanley estimates that half the world’s population enjoys fuel subsidies, and a quarter of the gasoline consumed worldwide is bought at less than market prices. Gas is five cents per liter in Venezuela, which is the cheapest price in the world. The Chinese pay $0.79 per liter, compared to Americans at $1.04 per liter and Germans at $2.35 per liter. Consumer demand in the emerging economies will not slow down unless the consumer is impacted by the higher prices.
This combination of increased demand and tight supply started the run-up in oil prices, but does it really explain $140 per barrel? Not by a long shot, according to Chicago-based market research firm Probability Analytics Research. They say that supply and demand account for a price of oil in the $60 to $75 range. The Saudi Arabian oil minister, Ali Al-Naimi, agrees with them and has suggested that the range should be $60 to $70. These estimates are considerably higher than what oil prices were in the last decade, but half the current price. So what is causing the difference?
Some have blamed the value of the dollar. Oil, like most global commodities, is priced in dollars and the value of the dollar has been falling. If the dollar is less valuable, then it will buy less oil, or so the argument goes. This is true to a point, but the dollar has not fallen nearly far enough to account for oil at $140 a barrel. So there must be something else.
Investors make up the difference, according to Mike Masters of Masters Capital Management, who notes that trading volume in oil futures markets has gone through the roof. For example, open interest in the West Texas Intermediate crude oil contract traded on the NYMEX (just one example on just one of several exchanges) has risen from less than 500,000 contracts in 2004 to more than 1.5 million contracts currently. Each contract represents 1,000 barrels of oil. Masters, in his testimony before a Senate sub-committee on May 20, 2008, estimated that the rise in investment interest has added an equivalent of 848 million barrels of oil to demand, roughly the same impact as increased demand from China.
Review of Economy
Pessimism continues to rule the economic talk, and I know I might shock and even offend some if I dare suggest that the apocalypse is not near. However, with oil prices where they are and the housing crisis only getting worse, the economy as a whole is surprisingly stronger than one would suspect. GDP growth for the 1st quarter 2008 was 1.0%. That is hardly robust, but it is positive which means even with all the bad press the US economy managed to grow. Most of the growth can be tied to exports. Exporters have been helped by the continuing weakness of the dollar which makes US goods less expensive for foreigners.
Unemployment has risen to 5.5% in June. The employment picture is getting worse as there are few new jobs being created. However, we do need to keep this in perspective; the average unemployment rate for the decade of ’90s (when all was good) was 5.76%. The Fed has lowered the fed funds rate by 0.25% to 2.00%, but has signaled that this could be the end of the easing cycle as the value of the dollar and inflation are becoming greater concerns.
Housing remains a big negative on the economy but it has been overshadowed this quarter by the run up in oil. Decreasing home values combined with greater inflation driven by oil and food prices have people feeling bad, and understandably so. But, we have made it through worse economic times before, and we will make it through this as long as pessimism doesn’t weigh us down, and Washington doesn’t “help” us into a real economic depression.
Review of Market
There is a destructive patterndeveloping in the markets as pessimism is out of control. When there is no real news, pessimism takes over and the market plunges. Then the news comes out and it is better than expected. The markets surge. Then there is no news and pessimism once again takes over. We have been in this cycle for a year and a half now and I fear it will last until the election.
The S&P 500 ended down 2.73% for the quarter after surging up over 6% in April and May. Growth outperformed value dramatically, and small companies did better than large. The Russell 2000 Growth index was up 4.47%. The Lehman Brothers US Aggregate Bond index was down 1.02% as the market anticipates rate hikes from the Fed, but the High Yield index ended higher, up 1.75% as historically low default rates suggest the credit crisis is overblown. International markets were in line with the US as the MSCI EAFE index fell 2.25%.
